Federal Reserve chairwoman Janet Yellen highlighted extreme uncertainly about how many more jobs the US economy can create before inflation picks up, in a speech to a symposium of central bankers that raised the possibility of earlier rate rises by the Fed.

Ms Yellen’s move to a more neutral position on the amount of spare capacity in the US labour market marks a shift from her strong signals earlier this year that underemployment in the US is high. It suggests there is a growing chance the Fed could lift interest rates from zero earlier in 2015 than markets currently expect.

Labour market progress

“If progress in the labour market continues to be more rapid than anticipated by the committee or if inflation moves up more rapidly than anticipated . . . then increases in the federal funds rate target could come sooner than the committee currently expects and could be more rapid thereafter.”

In her first Jackson Hole address as Fed chairwoman, Ms Yellen had to walk a tightrope between a speech with enough substance to match the occasion and one that gave away too much on policy. She solved the problem with a detailed address on labour markets – her own area of academic expertise. “With the economy getting closer to our objectives, the [Federal Open Market Committee’s] emphasis is naturally shifting to questions about the degree of remaining slack, how quickly that slack is likely to be taken up, and thereby to the question of under what conditions we should begin dialling back our extraordinary accommodation,” she said.

Her speech shifts the Fed into a new mode – one that is squarely focused on when interest rates need to rise rather than adding support for the economic recovery. Ms Yellen said working that out was “especially challenging” in the aftermath of the Great Recession, “which brought nearly unprecedented cyclical dislocations and may have been associated with similarly unprecedented structural changes in the labour market”. Those changes, she said, were not fully understood.

She said the Fed could not rely on rising inflation or wages as a sufficient guide for when the market has fully recovered – that could lead the Fed to move too early or too late.

Wage cuts

For example, she said, if companies were unable to cut wages as much as they wanted during the recession then at first they will not raise them during the recovery. “If so, the first clear signs of inflation pressure could come later than usual in the progression towards maximum employment,” she said.

That could lead the Fed to raise rates too late, leading to “an abrupt and potentially disruptive tightening of policy later on”.

On the other hand, slow growth in wages recently may mean there is more room for them to rise before they start to create inflation. That would be a reason for later interest rate rises. – Copyright The Financial Times Limited 2014